Value Investing For Mothers-in-Law: Forget What You Know About ...

My mother-in-law is known to my kids as Doodles. The name?s origin is a long story, but what?s important here is that she is extremely smart and a very capable businesswoman (she doesn?t go by ?Doodles? professionally). Despite her business expertise, she is always asking me questions about the stock market that seem to miss the underlying philosophy behind long-term value investing.
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In an effort to not seem like an evasive jerk, I will attempt to explain once and for all what I actually do.
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(For the record, Doodles is just a proxy for every social acquaintance who has ever asked me a question about the stock market. If I am addressing a dumb statement, assume that it was an insane distant relative who inspired my commentary. If the question is nuanced and complicated, assume it was the work of Doodles.)
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Last time we spoke, Doodles, I talked about competitive moats and how they help to define an investible universe of companies which are suitable for long-term investing (What 'Buy and Hold' Really Means). Today I will talk about Margin of Safety, the most holy of doctrines in value investing. Benjamin Graham, the father of value investing, coined the term, and every value investor from Warren Buffett to Seth Klarman has mentioned it. In fact, Klarman used the term for the title of his out-of-print book, which now sells for around $1,000 for a used copy (or if you were the ?value? sort, I suppose you could get it from a public library for less).
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Value investors find the Margin of Safety to be so important because most of us are wired to be extremely paranoid about losing money. Buffett has his two famous rules for investing:
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Rule No. 1: Never lose money.
Rule No. 2: Never forget Rule No. 1.
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Not only is that cute, but it also seems to have been effective for The Oracle.? Of course this doesn?t mean ?never take any risk,? nor does it mean that you should expect your investments? prices will only go up from the moment you buy them.? It just means that you should make sure there is a serious cushion between the current market price and the cumulative future cash flows of the business (discounted to the present).? You may get an analysis wrong occasionally and you will almost never buy at the bottom, but hopefully, large, permanent losses of capital will be rare.
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It is tempting to think of the Margin of Safety as a machine-like certainty.? ?I built a spreadsheet with my projections for the business and it currently sells for 60% of that discounted forecast.? Ergo: Margin of Safety.?? You have predicted the future and now you need only sit back and wait for mere mortal investors to catch up with your clairvoyant brilliance.
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The problem with this thinking is that you have framed the analysis as ?How do I win??? You have likely created a narrative that draws a straight line from the current price to your estimated intrinsic value. You may be right on the eventual price direction and you might get some parts of the story to line up with your fortunetelling, but it is pretty rare for everything to work out exactly how you planned.? Heck, half the time I make money on a stock it is for a reason completely different from my original thesis.? But by focusing on a linear catalyst or story, you are setting yourself up to violate Buffett?s rules about not losing because you have not thought through lots of different scenarios.

Long CVGI (personally or in accounts where I have trading authority).

Source: http://www.minyanville.com/business-news/editors-pick/articles/Value-Investing-For-Mothers-in-Law253A/2/20/2013/id/48246

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